The UK economy: are we the next Greece type crisis?

Whilst looking at the issues surrounding Greece for a few days I felt that it was time to look at her in comparison with the UK.Some of this was prompted by an analyst on Bloomberg who suggested that markets would now immediately move onto considering the UK’s position as she does not have the benefit of a “safety net” from the Euro zone. Looking at the comments section to my site I can see that I was not the only person looking at this.

Immediate thoughts on a “safety net”

I would imagine it has been fairly clear from my analysis that I think the so-called “safety net” from the Euro zone has got plenty of holes in it. Look at the dithering and grandstanding that has gone on in Europe over the past two months to come up with a plan which so far only addresses Greece’s liquidity and not her solvency problems and as I explained yesterday is unwieldy and has operational problems. Also consider the size of the UK’s economy compared to Greece, we are a much larger economy being around six times larger, and now consider the size of help we would need in such circumstances. Such help could simply not be afforded by the Euro zone and particularly not by the weaker constituents such as Portugal,Spain and Ireland. So yet more holes for the  concept of their being a possible safety net for the UK.

I must also admit to personal experience as I worked in the City of London through the UK’ s ejection from the Exchange Rate Mechanism back in 1992, now those were different times but I do remember hopes of assistance from Germany and others then, but these were never fulfilled. Ironically of course the ejection from the ERM and the subsequent depreciation of sterling’s exchange rate turned out to be one of the best things that has happened to the UK economy since the Second World War. As an aside it is not only now that the main political viewpoint and consensus has proved to be wrong. How some of these people retain their careers and receive advancement after such errors is an important question for our times.

As to the safety net in action we had an opportunity to see it work this week and not surprisingly for a safety net with holes its record is patchy. Greece issued some 1.2 billion Euros of Treasury Bills yesterday and there was considerable demand. However the  demand was not surprising as the interest rates were very high with her twelve month Treasury Bills issuing at 4.85% which compares with her previous issue earlier in the year at 2.2% and the six-month version issuing at 4.55% compared with 1.38% earlier in the year. Looking internationally then Greek’s reading this might like to sit down as this is ten times the rate the United States pays on hers. Looking up the yield on UK Treasury Bills also gives a rate of less than 0.5% and both our government bonds which expire in 2010 currently yield less than 0.5%. Greek ten-year bond yields remain stubbornly high at 6.73% which again is not much of a safety net.

The UK economy

Exchange Rate

We have a free-floating exchange rate which can adjust and move both to help and hinder us. This is a counterpoint to the idea of a safety net because Greece does not have her own exchange rate. Until this year the Euro exchange rate had moved unfavourably for Greece whereas the UK had a substantial depreciation from late 2007 to 2009 where our effective exchange rate fell by 25%. Over the recession this flexibility has so far been a strength.

Central Bank policy

We retain control over our own central bank and thereby have control over our own monetary policy. The “one size fits all” European Central Bank policy has plainly not fitted Greece at all well since she joined the Euro in 2001. I would argue that the implementation of Quantitative Easing in the UK was a policy mistake but it is unarguable that it is an arrow in our quiver which Greece does not have. We also can adjust base rate to fit our own circumstances rather than joining in with 15 others.

There is a deeper issue here and I have alluded to it in the past. You see contrary to perceived public wisdom central banks usually only control the price of overnight money and then their “influence” extends down the shorter end of the yield curve. This is a measure in my view of whether the central bank has authority over events. Now look again at the figures I quoted above for the US,UK and Greece. We and the US retain authority whereas it is plain that Greece does not. Of course this does not mean that we automatically do the right things with it merely that we have it and they do not.

Economic Data

Growth

Here is a gain for the UK when compared with Greece. Official figures for Greece now estimate that she will have growth of minus 2 % this year and I feel that this is an underestimate and minus 3/4% is more likely. There are dangers of a double-dip for the UK but I feel that we will have positive growth but not much say 1%. So 2010 shows a clear difference and as I fear for Greece in 2011 too, the fact that I believe official estimates for UK growth in 2011 are very optimistic at 3% does not hide the fact  we should grow but again probably not by 3%.

National Debt and fiscal deficits

Again we are on a different path as Greece has a national debt of 114% of GDP and the UK has one of 61% according to the Office of National Statistics. Whilst both are accelerating the UK does not have as much of a problem with her debt management and this is for two reasons. One is that the average term for UK debt is 14 years compared with Greece’s 7 to 8 years. So pound for pound our debt comes up for renewal less often. Also yields on our debt are much lower at around 4% for ten-year gilts as opposed to 6.73% for Greece. So we can still issue more cheaply.

The problem of the fiscal deficit is more of an issue for the UK as until recently we were competing with Greece to have the highest one in Europe. The recently announced expected rise in the Greek figures to at least 12.9% of GDP was however combined with an improvement in the UK’s figures to under 12%. So there was some temporary relief. Going forward however issues remain as whilst Greece has begun an austerity programme to reduce hers none of our political parties really seem to have grasped the scale of the task ahead (perhaps of course with an election soon this is deliberate….).

I do have concerns for the UK’s fiscal deficit for the next couple of years for the following reasons.

1.I do know of people who are self-employed who are putting their tax returns in early this year. As trading in 2009/10 was weak this will allow them to reduce their payments on account and I would suspect that they are far from alone and this is likely to impact on total tax revenue.

2. The implementation of the 50% income tax rate saw bonuses and other payments (and the subsequent tax revenue) shifted into 2009/10 from 2010/11. So this will have an impact. This may have been added to by the rumours of an increase in the rate of capital gains tax in the Budget which may have got people to declare gains in the 2009/10 tax year and thus temporarily boosted tax receipts. The capital gains tax rise never in fact happened.

3. Official estimates of growth rates for the UK economy are somewhat optimistic for this year and the forecast 3% for 2011 and 2012 of 3% each are very optimistic. Any shortfall here will impact on the deficit figures as tax revenues would fall just as public spending would rise.

4. Plans for public spending cuts in the UK simply have no detail and credibility at all.

Balance of Payments

Here both countries records are poor with both countries having substantial deficits. In 2009 Greece had a balance of payments deficit of approximately 10% of GDP. There was hope in 2009 that the combination of the UK’s currency depreciation and the world recession might lead to an improvement in our balance of payments but our seasonally adjusted quarterly figures as a % of GDP were,-2.3%,-2.4%,-2.2% and -2.5%. So not as bad as the third quarter of 2007 at 3.6% but not as good as one might have hoped from the currency depreciation and no real sign of a trend. This year has started with bad figures for January followed by better ones for February so again no clear trend.

Perhaps a better trend will emerge or of course it may be hidden in the numbers as of the economic statistics which are collected balance of payments figures are the most unreliable and subject to revision of them all.

Inflation

Here the UK does have a problem with inflation on the Consumer Price Index being 3% last month which is 1% over target. The recent rise in the oil price has been reflected in the producer price figures for March of this year so that upward pressure looks likely to remain for the rest of this year. Should this continue then this plainly is a danger for us as ten-year bond yields of around 4% are unlikely to be sustained with inflation of 3% and of course the older retail price index has an even higher reading.Our Monetary Policy Committee has invested a lot of their remaining credibility in the upturn in inflation proving to be temporary and events are already looking like they are moving against them.Should inflation prove to be a persistent problem through this year they will have made another policy mistake.

Conclusion

Whilst we are not yet the next Greece we do have two main problems going forward. Our fiscal deficit remains high and we have no real plan to reduce it. Inflation appears to be a specific UK problem and if it does not drop quickly then more eyes will turn to it internationally. So whilst there are real issues ahead I suspect that for now Greece will remain in the headlines and may well be joined by Portugal and Spain. We still have some time to respond ahead of events but it would appear that we are wasting it as events have helped us over this period which begs the question of what we would do if events turned against us.

Also markets are likely to wait for the election to see who is elected and to see what their real plans are.

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10 thoughts on “The UK economy: are we the next Greece type crisis?

  1. The upside risk to gilt yields I fear has more to do with inflation risk than default risk. There is a unspoken agreement I think between the BoE and both political groups to inflate debt out. The current real yield on 10 year gilts is barely positive and soon to turn negative

    Hot money will demand a yield premium for this risk. At that point the affordability of the plan for issuance between now and 2015 looks awful.

    The situation is a precarious but the BoE does nothing.We need to start slowly easing up base rate to try to restrain inflation expectations,fat chance.

  2. Shaun: “Should inflation prove to be a persistent problem through this year they will have made another policy mistake.” Is it not possible that this is not in reality a “policy mistake” nor in retrospect will it be seen to be such when the truth emerges, but that this was and is a deliberate political decision enforced by Brown, using the appropriate clauses of the MPC implementation definition, for the political expedient of inflating away government and household debt?

    In fact I cannot really understand why the MPC, if truly acting independently, would have taken continuous decisions completely in opposition to their sole remit for so long. If you look at even the Mickey Mouse CPI number for supposed inflation over the last 2 years, the “decisions” of the MPC have never been construed during that period to bring down inflation to target and then to ease, but rather to let it rip and hope that eventually things would correct naturally (after a significant debt reduction by means of inflation)? They also did not move during the housing runaway period to increase base rate to prevent inevitable fiscal runaway.

    There can be only one of two possible reasons for these errors I believe: either the MPC members are totally incompetent (which I doubt); or control has been taken out of their hands for a considerable period? In the latter case, the question has to be asked: what is the MPC there for if it cannot meet its own remit over such a long period, why do we need it, and why is a significant amount of Public Money being wasted by not abolishing it?

  3. It’s not just inflating away household and state debts, its inflating away all kinds of financial assets. People are not as stupid now as they were in the 1970’s but Brown (who clearly wants inflation to be significant while holding down interest rates – good luck!) is praying that they are. If he gets back into power, watch out for a significant flight of private capital from the UK, notwithstanding the possibly permanent devaluation of Sterling. If Cameron gets into power, well, let’s deal with that if it happens!

  4. Inflationary policies were operated hand in hand with exchange control measures. Any attempt to do so again would be totally futile.I pray any ‘pound in your pocket’ policy being hatched has accounted for this.

    For those who wish to show their wrinkles and/or bald heads remember the pricecheck triangle?

  5. The underlying economic strategy of the UK for the last few years seems to be more about the continuation of the political class rather than any real national benefit. Blaming Greece and her politicos of the time for fiddling the figures to gain membership of the EMU is akin to us being treated as mugs now going into a national election as not one of them has come up with a workable plan going forward to resolve the huge fiscal problems we have. Greece is paying a heavy price for the trust her people put into their political class are we about to make the same mistake?

    Andy, being neither wrinkled nor bald………… the pricecheck triangle??????

    • Price check was a one of Callaghan’s measures to control soaring inflation.It was a voluntary scheme with retailers who displayed a red price check triangle in shop windows in exchange for restraint in pricing

      It was a miserable failure in the style of King Canute

    • It is analagous in my mind to an off balance sheet item. Leaders meet and decide to raise the IMF’s potential loan capital by $500 billion and hey presto a year later it is there!
      Just like a magic trick and there is the problem. We in the UK had a bilateral agreement to loan $15 billion if necessary since last September as a lead into this. I notice that it was set up as a recurring one year deal which immediately triggered a thought at the back of my mind that such a term might be sufficient to stop it going into the national accounts. In a sense the IMF may have struck free money!

      At the same time the IMF’s role has also shifted from dealing with exchange rate and balance of payments problems to fiscal problems hasn’t it? Whilst Greece does have a balance of payments problem her real problem is fiscal.

      Both are events that again have clear moral hazards, just at a time when financial issues are revealing moral hazards previously hidden from the general public

  6. Hi Shaun,

    I read your blog with interest as it provides a considered response and focuses on the UK and Europe.
    I keep reading that the govt will inflate away our debt, but have also read @ “The Market Ticker” by Karl Denninger, that this would create a problem as off balance sheet liabilities such as social security and the NHS are indexed to inflation. I wondered what your thoughts on this are.

    Best Regards.

    • Hi Jacqui
      If we just take the UK as an example there is a clear moral hazard that the biggest debtor is the government. Whilst we do have some of our national debt index linked to inflation the majority of it is fixed interest. So there is a clear incentive here for them to encourage inflation to reduce the real value of the debt.This will increase as our national debt rises which it will for the next 3/4 years under current plans. There are indeed off balance sheet items such as public sector pensions which in the main are indexed to inflation but these would be impacted over the longer term as the real bills for these are a lot further into the future. Whilst I do think about the longer term I suspect our politicans do not. So in their time-frame it will look tempting and our politicians model themselves on Oscar Wilde’s “I can resist anything except temptation” I think.

      Some of the other things which are linked to inflation also could be changed by governments for example some years ago the link between the basic state pension and earnings was cut by Mrs Thatcher if I remember correctly.

      Also there is a difference between US and UK index-linked government debt. At times US index-linked debt (TIPS) have got quite cheap during this crisis if you do a valuation but UK index-linked gilts did not particularly and in relative terms are now very expensive (expressed as real yields being very low) so if the UK wishes to issue new stock, which of course it is going to have to do a lot of, there is plenty of scope for new index-linked issues, but it seems to slip its mind which is inconsistent with its expressed inflation forecasts…….

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